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June 4, 2014

Sallie Krawcheck Proves Everything's an Index Fund Now

Here is a story about the marketing of financial products. Sallie Krawcheck is doing some stuff with the women's network that she bought last year, changing its name from 85 Broads1 to Ellevate,2 and using it to offer "an index fund focused on companies where women make up a significant portion of officers and directors":

The fund is effectively a joint venture between Ms. Krawcheck and Pax World Management. With a new company she and a partner created, Ellevate Asset Management, Ms. Krawcheck bought a stake in the manager of a fund called the Pax World Global Women’s Equality Fund. Under the deal, the fund is now the Pax Ellevate Global Women’s Index Fund.

Now, notice that name change. From "Pax World" to "Pax Ellevate," for the joint venture, sure. But also from "Global Women's Equality Fund" to "Global Women's Index Fund." Now an "equality fund" is not a technical term, but an "index fund" is. Actively managed mutual funds pick stocks to invest in, and then invest in them, hoping to beat some benchmark. Index funds just invest in all of the stocks in an index, hoping to match the performance of the index.3

The Women’s Index is a customized market-weighted index consisting of equity securities of issuers organized or operating in countries around the world that demonstrate a commitment to advancing and empowering women through gender diversity on their boards, in management and through other policies and programs, and an understanding of the potential business advantages associated with greater gender diversity, as rated by Pax World Gender Analytics.

Yes okay fine but how will MSCI actually decide on the specific companies that go in the index?

In connection with each annual re-constitution of the Women’s Index, Pax World Management LLC (“PWM”), the majority owner of PEM, provides MSCI with the names of the issuers to be included in the Women’s Index.

Oh I see. So Pax World Gender Analytics4 will subjectively rate companies on their commitment to women, Pax Ellevate Management will then choose a list of the companies that Pax World Gender Analytics rates highly, Pax Ellevate Management will give MSCI that list, MSCI will call that list an index, and Pax Ellevate Management will then invest its index fund in that index.

Now, of course: Fine. There is not a ready-made list of companies that treat women fairly. Somebody should make that list, not only because it has important public interest ramifications but also because those companies are sort of obviously going to be better investments than those that don't.5

Making that list will necessarily be a subjective process, but Sallie Krawcheck runs a group devoted to advocating for and investing in women, and it makes sense for that group to make the list. And then to go invest in the companies on that list.

But making a list of companies that you think are good investments, and then buying the stocks on that list, is usualy called "active management," as distinct from "indexing," which is just taking someone else's list of companies and buying all the stocks on that list.

The investment process of the Pax Ellevate Global Women's Index Fund -- make a list of companies that are good for women, and then invest in those companies -- sounds a lot like the investment process of the Pax World Global Women's Equality Fund. Only the name has changed.

Pax is not alone: "Index fund" creep has been going on for a while now, with "smart indexes" and "custom indexes" and "improved indexes" and "fundamental indexes" and other things that are active management but that are called index funds. From an investor's perspective,6 this fund seems to offer some of the key disadvantages of an actively managed fund: high management fees to pay for all that research,7 and the possibility of, you know, not beating the market.

But it also has some of the key disadvantages of an index fund: The index is market-cap weighted, so Pax Ellevate can't overweight stocks that it thinks are particularly undervalued,8 and it adjusts only once a year, so Pax Ellevate can't respond quickly to changing conditions. (In fact, Pax Ellevate is required to publish the list of changes to the index before it can change its investments, so it can easily be front-run.9)

If you were just an investor with the investing thesis that companies that empower and promote women are good investments, the right investing decision would be to just buy the stocks of those companies, weighted by how much they empower women and how good an investment you think they are, without giving away too much about your investment-decision secret sauce. That seems to have been the strategy of the Pax World Gobal Women's Equality Fund, and it worked okay.10

On the other hand, if you wanted to promote this investing thesis -- to get investors for your fund, or to advocate for the empowerment and promotion of women in business, or both -- calling it an "index fund" has a certain appeal. Index funds are hot right now, so investors who wouldn't buy a Women's Equality Fund might be thrilled to buy, or at least pay attention to, a Women's Index Fund. And calling it an index, and publishing the names in advance, might encourage other investors to copy your investing strategy, or compare themselves to it. That, in turn, might make companies want to be in the index, which might encourage them to treat women fairly. As an investment in women, if not as an investment in stocks, calling this an index fund makes sense.

1. As this name passes from the world, four years after it stopped making sense, let us take a moment to mourn it. It is one of the very greatest of all financial-industry puns. And that's a crowded field.

2. Ehhhh.

3. This is loose; typically they try to match an index closely but without necessarily tracking its exact composition. The Pax Ellevate plan is not unusual:

The Global Women’s Index Fund employs an index-based investment approach intended to closely correspond to or exceed the performance of the Women’s Index, while maintaining risk characteristics that PEM believes are generally similar to those of the Women’s Index. Under normal circumstances, the Global Women’s Index Fund invests more than 80% of its total assets in the component securities of the Women’s Index ... PEM intends that, over time, the correlation between the Global Women’s Index Fund’s performance and that of the Women’s Index, before fees and expenses, will be 95% or better.

4. I don't know what this is. Google turns up mentions of it only in the marketing materials for this index fund.

Now of course "companies that hire and promote women will have better business performance than companies that don't" is different from "companies that hire and promote women are undervalued investing opportunities." Perhaps investors already know this, or, put another way, perhaps equity markets are more efficient than hiring managers. There is a certain intuitive appeal to that theory, but also some evidenceagainst it.

6. When I wrote about improved indexing before I pointed out that, from the fundmanager's perspective, it offers the best of both worlds: The high fees and high profile of an active fund, with the low workload and investor interest of an index fund:

7. The Pax Ellevate Global Women's Index Fund charges a management fee of 0.74 percent, and a 0.25 percent 12b-1 fee for small investors, for total expenses of 0.74 to 0.99 percent. According to the Investment Company Institute, actively managed equity funds had an average expense ratio of 0.92 percent in 2012, versus 0.13 percent for index equity funds.

8. Or even those that are particularly woman-friendly compared to the rest of its list. Now, importantly, this is true of the index, to which the fund wants to be 95% correlated, but it is not necessarily entirely true of the fund. In fact:

The Global Women’s Index Fund generally invests in all of the components included in the Women’s Index, but may use a representative sampling strategy, or an optimized or enhanced strategy, to achieve its investment objective, weighting companies with more favorable characteristics with respect to women’s empowerment (e.g., number of women in executive positions or on the board of directors) more heavily than the Women’s Index, which uses market weights exclusively. As a result, the Global Women’s Index Fund may not always hold the same securities in the same proportions or weightings as the Women’s Index.

9. Because, remember, this thing is an index, not just a fund, so Pax Ellevate can't trade on inside information about what companies will go in the index that it's constructing:

PWM and PEM have adopted policies and procedures designed to address conflicts of interest between PWM’s role in the creation and maintenance of the Women’s Index and PEM’s role in managing the Global Women’s Index Fund. These policies and procedures prohibit the Global Women’s Index Fund’s portfolio managers, who are joint employees of PWM and PEM, from acquiring, for the Global Women’s Index Fund or their own account, securities under consideration for inclusion in the Women’s Index, and from selling, for the Global Women’s Index Fund or their own account, securities under consideration for removal from the Women’s Index, until MSCI has published the re-constituted Women’s Index. As a result, the Global Women’s Index Fund will be unable to benefit from any advance knowledge by the Global Women’s Index Fund’s portfolio managers of changes to the composition of the Women’s Index.

10. Just okay though. The fund outperformed its benchmarks (the MSCI World Index and the Lipper Global Large-Cap Core Funds Index) for the last year, but underperformed for the longer reported periods (3, 5, and 10 years).